Arise, Draghi the optimist

Commentary: Why Draghi will back Monti over Berlusconi

LONDON (MarketWatch) — Mario Draghi, the European Central Bank president, is fast gaining a reputation that no central bank governor should really seek to attain – that of an optimist.

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Central bankers are supposed to be paranoiac about inflation, detecting storm clouds on the sunniest of days and taking away the punch bowl of excessive liquidity just when the economic party starts to get going.

Draghi seems to have decided that given the generally pessimistic backdrop to the European economy, he has nothing to lose, and much to gain, by reinforcing a spirit of growing confidence about the ability of Economic and Monetary Union members to solve their problems.

Draghi has his eye on a major milestone in the European debt crisis: the Italian parliamentary election, probably on Feb. 24. This could lead to two totally disparate outcomes, with diametrically opposite effects on the euro.

The first would be Mario Monti continuing in power. Monti has been leading a technocratic government in Rome since November 2011, and — even after his resignation on Friday and his saying on Sunday that he will not run in February’s poll — he could end up at the helm of a broad reformist centrist coalition.

The second, looking less probable according to opinion polls, would be the return of former Prime Minister Silvio Berlusconi, leader of the center-right People of Freedom party. Berlusconi’s increased anti-euro pronouncements in recent weeks have been adding to nervousness about a drifting apart of EMU economies.

The first outcome would cement the improvement of Europe’s fortunes and narrow further the yield gap between Italian and German government bonds. The second would raise fresh doubts about whether the euro will survive.

Tortuous background

Draghi, previously governor of the Banca d’Italia, owes his present job to Berlusconi’s support when in office. But today’s ECB president (together with his predecessor, Jean-Claude Trichet) played a major role in bringing Berlusconi to heel (and eventually out of government) with their now-celebrated August 2011 letter to the then prime minister calling for economic reforms, effectively as a condition for ECB support for Italian government bonds.

Given this tortuous background, and the far-reaching implications of the Italian elections, Draghi can be expected to do everything within his power, overt and covert, to maintain Monti as the most credible candidate for continued office. And in view of his success so far with the high-stakes financial bluff of the ECB’s untested Outright Monetary Transactions program, Draghi has potent cards in his hand.

The idea that he’s trying to play them to best advantage was clear last week, when he told the European parliament that the euro-area economy has the “best fundamentals” among major economies — and he played up forecasts that the euro economy will be on the mend as 2013 wears on.

Reuters

European Central Bank President Mario Draghi at the conference "Growth and integration in solidarity: what strategy for Europe?" in Paris on Nov. 30, 2012.

Draghi’s optimism stands in contrast to the sobriety of leading forecasters such as the Paris-based Organization for Economic Cooperation and Development.

The OECD has spoken of the 17-nation euro bloc as the greatest threat to the world economy, forecasting a GDP contraction of 0.1 % next year before growth of 1.3% in 2014. In reality, though, Draghi and the OECD are talking about the same phenomenon. Given the size and duration of the European growth dip, and based on the day-follows-night principle, recovery, when it eventually comes, will be relatively fast.

Different bases of comparison

Draghi has placed emphasis on the brightest spots of economic adjustment. In his testimony to the European parliament, he highlighted a rise in goods and services export volumes since 2009 of 27% for Spain, 14% for Ireland, 22% for Portugal and 21% for Italy.

The rebalancing of problem-hit euro members’ economies toward exports, bringing big improvements in these countries’ previously chronic current-account deficits, has been aided in most cases by significant internal devaluations of their currencies though a sharp fall in unit labor costs.

This is a sign of how the euro is acting in a very similar way to the classical gold standard, under which countries facing gold outflows automatically tightened belts and adjusted their economies so as to encourage gold inflows. This phenomenon was forecast years ago by leading German policy makers such as Hans Tietmeyer, who was Bundesbank president when the euro was introduced — although he warned that adjustment could be highly painful (as it has been).

Comparing export improvements across the euro area, Draghi’s interpretation relies much on the choice of 2009 for the comparison, a year of world slump. Since then, all countries’ exports have risen appreciably. The Bundesbank, by contrast, has selected for its export comparisons the more realistic year of pre-crisis second-quarter 2008. Since then, real exports have risen by 10% in Ireland, 7% in Spain, 6% in Portugal and 5% in Italy – compared with 10% in Germany.

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One of the most potent reasons for euro optimism in fact centers on German exports – reflecting demand from outside the euro area. Buttressed by the relatively low value of the euro as well as by insatiable demand from fast-growing areas of the world for German capital goods, German export prowess is still powering the country’s growth machine and is one reason the Germans will avoid recession next year.

On latest months’ figures, China is catching up on France even more quickly than expected as Germany’s principal trade partner, with overall German-Chinese trade turnover (exports and imports) exceeding German trade with France for August (the latest month for which data are available) for the first time.

Although European exports are becoming progressively less relevant for Germany (only a bit more than a third of German exports and imports are now within the euro area), buoyant trade elsewhere is likely to convince the Germans that the euro show is worth keeping on the road.

One thing that could scupper this relative buoyancy would be the return of Berlusconi – which explains why Draghi will be working away behind the scenes to ensure that it doesn’t happen.

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